Not All Tax Cuts Are Good Tax Cuts

04/19/2013 05:45 EDT
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Updated
06/19/2013 05:12 EDT

Milton Friedman was famous for his one-liners. One of his most repeated lines was: "I am in favor of cutting taxes under any circumstances and for any excuse, for any reason, whenever it's possible." Friedman believed government was too large and intrusive, and that by cutting taxes, the size of government would be reduced.

There is no doubt as to the contributions made by Friedman, along with his wife Rose, over the course of their lives. Friedman's academic work led to insights across a wide range of issues including inflation and unemployment, the nature of consumption, and economic methodology, to name just a few. For his efforts and accomplishments he was rightly awarded the Nobel Prize in economics in 1976.

It is, therefore, with more than a little trepidation that we quibble with Friedman about the efficacy of tax cuts anytime, anyplace, and for any reason.

Our disagreement lies in the ability of any tax cuts to achieve their prescribed ends: namely shrinking the size of government. Remember, it was not tax cuts per se that Friedman advocated but rather a retrenchment in the state.

Our view, which we developed in a recent study entitled Tax Payers and Tax Takers, is that tax relief that results in larger and larger shares of the population being exempt from paying any meaningful taxes leads to more demand, not less, for government.

The trouble with removing large numbers of people from the cost of paying taxes is that it establishes the foundation for ever-increasing demand for more government programs regardless of their actual benefits. The democratic decision-making process gets distorted when large segments of the population are relieved of paying the cost of government.

An example of this phenomenon is playing out in the U.S. In 2011, according to the Tax Policy Center, a little more than 46 per cent of American tax units -- individuals or households -- paid no federal income tax. Almost 28 per cent paid neither income nor payroll taxes. As the U.S. has no national sales tax, this means more than one-in-four Americans see no direct cost for the federal government.

Even when all federal taxes are included, a significant percentage of Americans simply don't have any real skin in the tax game. In 2011, the bottom 40 per cent of earners in the U.S. paid just 2.9 per cent of all federal taxes while earning a little over 12 per cent of total income.

The only group that shoulders more taxes proportionately than they earn are the top 20 per cent. They pay almost 70 per cent of the total tax burden while earning 55 per cent of total income. The U.S. now relies on top earners to a greater extent than any other industrialized country for its revenues.

One of the reasons so many Americans are exempt from income and payroll taxes is the Earned Income Tax Credit (EITC). The EITC was originally introduced in 1975 to assist low-income workers in overcoming what was called the welfare wall. As low-income workers earn more income either by working more or getting better jobs, they often lose benefits and subsidies. The EITC was designed to assist them through this transition.

The problem is the EITC has grown from a targeted program for low-income workers to a general program benefitting many middle-class households. One sign of its expansion is that almost one-in-four American families now qualify for EITC benefits whereas only nine per cent qualified in 1975.

The building blocks for such problems are now present in Canada. In 2007, Canada introduced its version of the EITC, the Working Income Tax Benefit (WITB). In 2009, WITB was increased markedly, increasing in cost to a little over $1 billion from $480 million. This in part explains the increase in the percentage of Canadian tax-filers who face no federal income tax, which has already increased to 37.7 per cent in 2010 from 32 per cent in 2000.

The experience of the United States is a cautionary tale for Canadians as we potentially begin down a similar path. That is not, however, to say that we do not favour tax relief. Indeed, we have repeatedly explained why large-scale personal income tax relief must be on the agenda over the course of this decade. It is the one area of taxes where Canada remains woefully uncompetitive.

The key to tax relief is that it balances the need for lowering the burden of government (i.e. reducing tax rates) against having citizens -- excluding those with low income -- pay some visible price for government. (The GST achieves much of this latter goal, which is one reason we opposed its reduction.)

That balance looks something like a dramatically simplified income tax system with fewer and lower tax rates, a drastic reduction in the loopholes, privileges, and tax credits in the tax system, and a national sales tax. In other words, we need tax cuts but the right ones.

This column was co-written with Niels Veldhuis, Fraser Institute president.